Tag: Trade policy

Russian Wheat Policies and Georgia’s Strategic Trade Policies

Posted on March 11, 2024 | Policy Brief

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Russia is known for periodically halting its grain exports to impact global wheat prices. This has become a significant policy concern in recent years, most notably during the Covid-19 pandemic and in the wake of Russia’s war in Ukraine. Georgia heavily depends on wheat imports, and over 95 percent of its wheat has historically been sourced from Russia. Despite Russia’s periodic bans and restrictions on wheat exports occurring every 2-3 years, Georgia is yet to effectively diversify its sources of wheat imports. This policy brief analyses the impact of Russia’s most recent wheat policies on Georgia’s wheat market, examines Georgia’s response, and provides policy recommendations in this regard.

In June 2023, the Georgian government introduced a temporary import duty on wheat flour imported from Russia in response to requests from the Georgian Flour Producers Association. The association began advocating for an import duty after Russia, in 2021, imposed a so-called “floating tariff” on wheat which made it relatively more expensive to import wheat in comparison to wheat flour. As a result of the “floating tariff” on wheat, wheat flour imports skyrocketed and almost fully substituted wheat imports. Eventually, many Georgian mills shut down and local wheat producers struggled to sell domestically produced wheat. Such an increase in flour imports raises the risk of completely replacing domestically produced flour with flour imported from Russia.

To address the above, the government has implemented a temporary import duty of 200 GEL (75 USD) per ton on wheat flour imported from Russia (the average import price ranges between 225 USD/ton and 435 USD/ton). In turn, millers have agreed to purchase 1 kilogram of wheat from Georgian farmers for 0.7 GEL (0.3 USD). This policy measure is in effect until March 1, 2024.

The Georgian Flour Producers Association advocates for an extension of the temporary import duty beyond March 1, 2024, to uphold fair competition in the wheat and flour market. According to the Georgian Flour Producers Association, an extension is desirable due to the following (Resonance daily, 2024):

  • Under the import duty, fair competition between wheat flour and wheat has been restored, and Georgian mills have resumed their operations.
  • Following the government intervention, farmers have successfully sold over 50,000 tons (on average half of the annual production) of domestically produced wheat. The Ministry of Environmental Protection and Agriculture has reported a 60 percent increase in local wheat production over the past two years, with expectations of sustained growth.
  • Wheat imports have resumed, with Georgia importing 20,000 to 25,000 tons of wheat monthly, while prior to the government intervention, the average monthly wheat imports amounted to 15,337 tons (in 2022). Additionally, 8,000 to 12,000 tons of wheat flour, on average, are also imported monthly, while in the absence of government intervention, wheat flour imports surged to over 15,000 tons (in 2022).
  • Post-intervention, the price of 100 kilograms of first-quality flour has remained stable, ranging from 45 to 49 GEL. Consequently, the price of bread has not increased but remains steady.
  • The import duty has generated an additional 20 million GEL in government revenue.
  • Through the efforts of the mills, the country now enjoys a steady and strategically managed supply of wheat, in accordance with UN recommendations. Coupled with the seasonal harvest of Georgian wheat, this ensures complete food security in any unforeseen critical scenario.

While many arguments support the decision to preserve the import duty on wheat flour, in order to make an informed decision on that matter, it is essential to thoroughly assess production, trade and price dynamics in the wheat market in Georgia. Additionally, to design adequate trade policy measures, one has also to consider the issue in a broader perspective and assess the risks associated with a high dependency on Russian wheat, especially given Russia’s history of imposing wheat export restrictions.

Russian Policy on the Wheat Market

Russia has long been one of the dominant players on the global wheat market, and its periodic decisions to halt grain exports have heavily affected international wheat prices (see Table 1). This concern became especially stringent in recent years, during the Covid-19 pandemic and Russia’s war in Ukraine.

Table 1. Russia’s policy interventions in the wheat market and their estimated impact on wheat prices, 2007-2023.

Source: United States Department of Agriculture, 2022.
The Government of the Russian Federation.
The Kansas City Wheat Futures, The U.S. Wheat Associates.

One of Russia’s most recent interventions in the wheat market is its withdrawal from the Black Sea Grain Initiative – an agreement between Russia, Ukraine, Turkey, and the United Nations (UN) during the Russian invasion of Ukraine on the Safe Transportation of Grain and Foodstuffs from Ukrainian ports. While Georgia doesn’t directly import wheat from Ukraine and isn’t immediately threatened by famine, Russia’s export policies regarding wheat have raised significant food security concerns in the country. Georgia heavily depends on wheat imports from Russia, with over 95 percent of its wheat historically being sourced from there. Despite Russia’s recurrent bans and restrictions on wheat exports every 2-3 years, Georgia is yet to successfully diversify its import sources.

The Georgian Wheat Market in Figures

Domestic Production

Historically, Georgia’s agricultural sector has struggled to achieve a large-scale and sufficient wheat production due to the prevalence of small-sized farms. However, over the past decade, Georgian domestic wheat production has shown significant growth (see Figure 1). This growth has been particularly sizeable in recent years, with production increasing by 32 and 53 percent in 2021 and 2022, respectively, as compared to 2020.

Figure 1. Wheat production in Georgia, 2014-2022.

Source: Geostat, 2024.

Such increase in local production positively contributes to the self-sufficiency ratio, which increased from 7 percent in 2014 to 22 percent in 2022, in turn implying higher food security levels.

Wheat Imports

Before the introduction of Russia’s floating tariff on wheat, wheat flour imports to Georgia were almost non-existent. However, after the floating tariff was imposed on wheat, imports of wheat flour increased more than 20 times – from 743 tons in January 2021 to 15,086 tons in May 2023 – peaking at 23,651 tons in August 2022 (see Figure 2). At the same time wheat imports declined by almost 60 percent, from 29,397 tons in January 2021 to 12,133 tons in May 2023, with the smallest import quantity being 2,743 tons in May 2022 (as depicted in Figure 2).

Figure 2. Georgian wheat and wheat flour imports, 2021-2023.

Source: Geostat, 2024. Note: Imports include meslin (a mixture of wheat and rye grains).

After the introduction of the temporary import duty on wheat flour in June 2023, wheat imports have picked up, although not reaching the levels seen in 2021. Similarly, wheat flour imports have declined while remaining at higher levels than in 2021. This indicates a change in Georgia’s wheat market dynamics. Historically, Georgia predominantly imported wheat; now it imports both wheat and wheat flour. This shift must be considered in future policy design, as it has implications for domestic wheat farmers and mills.

The continued wheat flour imports, despite the temporary import duty imposed by the Georgian Government can likely be attributed to a smaller price gap between wheat and wheat flour import prices (see Table 2).

Table 2. Average import prices of wheat and wheat flour in Georgia, 2021-2023.

Source: Geostat, 2024.

In 2021, prior to Russia’s introduction of a floating tariff on wheat, the import price of wheat flour in Georgia was 24 percent higher than the import price of wheat. After the introduction of the floating tariff, importing wheat became more expensive, and the import price gap between wheat flour and wheat decreased to 22 percent by the end of 2021. Subsequently, in 2022, this gap further narrowed, and by the first half of 2023, the import price of wheat flour was 5 percent lower than the import price of wheat. This significant decrease in the price gap resulted in nearly full substitution of wheat imports with wheat flour imports. After the introduction of the import duty on wheat flour and as international wheat prices declined, a marginal positive price gap has reappeared, amounting to just 1 percent. As it stands, importing wheat flour remains more advantageous than importing wheat.

Price Effects

Russia’s floating tariff on wheat led to increased bread and wheat flour prices in 2021-2022. In June 2022, bread prices experienced the most significant surge, increasing by 36 percent, while wheat flour prices reached their peak in September 2022 with a year-on-year increase of 41 percent (see Figure 3). The primary reason for this was the record increase in wheat prices, leading to a corresponding surge in wheat flour prices in 2022. This spike occurred as the world price of wheat reached its highest point in five years.

Figure 3. Annual change in bread and wheat flour prices, 2021-2023.

Source: Geostat, 2024.

Nevertheless, in 2023 bread and wheat flour prices decreased, indicating that the import duty on wheat flour did not lead to increased prices. This could partially be explained by the fact that mills pay farmers 0.5 GEL/kg, which is lower than agreed price of 0.7 GEL/kg. Another and more crucial factor is the decline in global wheat prices. They began their descent in June 2022 and have since maintained a downward trajectory. This decrease, combined with increased local production, has so far acted as a barrier to any new bread and wheat flour price increases.

The Way Forward

The question that must be addressed is whether the import duty on wheat flour imported from Russia should be extended.

The import duty may have contributed to increased local production as higher import duties can incentivize local businesses to invest in expanding their production capacity or improving their technology to meet an increased demand. It is however essential to note that the impact of import duties on local production varies depending on the level of domestic competition, the availability of inputs (high quality seed, fertilizer etc.), technological capabilities, and government policies beyond import duties (such as investment incentives, infrastructure development, and regulatory environment). Additionally, import duties can also lead to retaliatory measures from trading partners, affecting overall trade dynamics – potentially incurring unintended consequences. Therefore, while import duties can contribute to an increased local production under certain conditions, it is just one of many factors influencing production dynamics.

Secondly, as previously detailed, the import duty has so far not resulted in increased bread prices. However, the effect of an import tariff on retail prices depends on various factors, including elasticity of demand and supply, market, competitiveness, and the extent to which the tariff is passed on to consumers by importers and retailers. Since demand for bread is inelastic, one has to keep in mind that the importers and retailers can fully pass on the increased cost from an import tariff to consumers.

Given that the floating tariff and the import duty make wheat and wheat flour imports to Georgia more expensive, one should expect future bread price increases. This unless international wheat prices continue to decline and/or producers agree to reduce their profit margins or make supply chain changes. Therefore, an extension of the import duty might be a suitable solution in the short and medium-term, but it should not be seen as a permanent solution.

To limit the risks of food scarcity in Georgia in the long run, it is essential to design strategies helping the country to reduce its dependency on Russian wheat and wheat flour. Some measures to achieve this objective may include:

Further supporting local production. Encourage investment in domestic agriculture to increase the productivity and quality of wheat production in Georgia. This can be achieved through subsidies, incentives for modern farming techniques, and access to credit for farmers.

Improving the quality of local production. Currently, most of the domestically produced wheat is unsuitable for milling into wheat flour. A significant portion of domestically produced wheat is of poor quality and instead used for feeding livestock. It is essential to invest in research and development to improve the quality of domestically produced wheat. This includes developing wheat varieties that are resistant to diseases and better suited for local growing conditions.

Seeking alternative markets for import diversification. One alternative for Georgia may be to focus on the Kazakh and Ukrainian markets (once the war is over) and negotiate possible ways to decrease the cost of transporting wheat to Georgia with state and private sector representatives.

Reducing the Georgian dependence on Russian wheat imports requires a multifaceted approach that addresses various aspects of agricultural policy, trade diversification, and domestic production capacity.

References

Resonance daily. (2024). The Association of Wheat and Flour Producers of Georgia requests an extension of the import tax on imported flour. https://www.resonancedaily.com/index.php?id_rub=4&id_artc=197847

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

US-China Trade War of 2018 and Its Consequences

Posted on December 17, 2018 | Policy Brief

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The trade war between the United States and China has become one of the main events in the global economy this year. What could be its consequences for the US and China, and how might it affect other countries – for example, Russia? 

Chronology of the trade war

Donald Trump started the war, raising import tariffs on solar panels in January 2018, of which the main supplier is China. In response, on April 2nd, China raised import duties on 128 commodities originating from the United States. On July 6th, the US increased tariffs on Chinese goods by 25 pp., imports worth $34 billion. China responded symmetrically. In August, the United States increased the tariffs on another $16 billion of imported goods from China, to which a symmetrical response again followed. In September, the United States again applied higher tariffs for $200 billion of Chinese exports, and China for $60 billion of US exports. At each stage of the conflict escalation, China appealed to the WTO with complaints about the actions of the United States, pointing to the inconsistency of their actions with the obligations and principles of the WTO. There were several meetings of official representatives from the United States and China – without any significant results.

What are the main reasons for this unprecedented escalation?

Imbalance and intellectual property

The economies of the US and China today are by far the largest in the world, and the trade turnover between the two countries is one of the most important. A remarkable feature of these trade flows over last decades is their imbalance. In 2017, the United States imported $526 billion worth of goods from China, while China’s imports from the United States amounted to $154 billion. Part of this imbalance is offset by trade in services, but it is not enough to even it out: in the same the year the United States delivered $57 billion worth of services to China while importing services of $17 billion from China.

Experts have different views on this imbalance. On the one hand, there is a perception that it is a source of world economy vulnerability, a source of potential crisis. Therefore, it is necessary to reduce the trade deficit. Another point of view is that this imbalance merely reflects the fact that the US economy and its assets are very attractive to investors from all over the world, including Chinese – and that, in turn, requires that the surplus of capital flows biased to US side, was compensated by the corresponding deficit of trade in goods and services. One such investor is the Chinese state itself, which for many years has been pursuing a policy of exchange rate undervaluation in order to promote foreign trade. It led to an enormous accumulation of foreign exchange reserves and as of January 2018, China held $1.17 trillion of US bonds and was the largest creditor of US government.

US President Donald Trump referred to this trade imbalance as one of the reasons for the outbreak of this trade war against China. Trump aims at reducing the deficit by $100 billion from the current $375 billion. The unilateral increase in import tariffs applied to Chinese goods was the first action of the US administration in this direction.

The second, no less important, formal reason for the trade war is the inadequate protection of intellectual property rights in China. China’s production of counterfeit products, the lack of adequate practices and laws to protect foreign technologies from illegal dissemination in the country, is not news to anyone. And although the almost two decades since China’s WTO accession have meant a largely modernized legal framework in this regard, a number of important provisions are still inconsistent with international practices, and the implementation of existing intellectual property rights leaves much to be desired. Established in 2012, The Commission on the Theft of American Intellectual Property identifies China as the most malicious violator of US rights. The exact damage is not known, but the commission assessment of the losses to the American economy due to the forced transfer of technology to Chinese partners – which is an unspoken condition of foreign manufacturers access to the Chinese market – industrial espionage, contradictions in legislation, requirements for the storage of sensitive data in China are in the range from $225 to $600 billion per year (Office of US Trade Representative, 2018).

While both the trade deficit and the intellectual property rights issue were recognized for many years, it was in 2018 that Trump started acting on them. Therefore, in order to discuss the potential impact of the conflict between the world’s largest economies on themselves and other economies, such as Russia, it is important to understand what drives the actions undertaken by Trump’s administration.

Populism

Trump won the elections in 2016 with a minimum margin against the Democratic rival. To provide support for his decisions and to increase the chances of being reelected for the next term in 2020, it is crucial to maximize the pool of his supporters. Trade policy measures aimed at import substitution are very effective populist policies in any country. One of the first steps made by the US toward trade war was the increase in import tariffs on steel and aluminum – for all countries. Metallurgy and coal industries are among the most organized and strong lobbyists in any country. The European Union as an economic organization started with the European Coal and Steel Association. By aligning interests with these sectors much can be achieved in relation to trade liberalization, and vice versa – by increasing the level of protectionism, a significant popularity increase can be among voters whose incomes depend on the success of companies in these industries.

Deterrence

China works hard raising the technological level of its economy. In recent years the Chinese government and Communist party launched a number of ambitious programs aimed at achieving a technological breakthrough, lessening the dependence on imported technologies by substituting them with ones produced by domestic innovation centers. These programs specify the priority sectors, in which state subsidies are provided for the acquisition of foreign technologies by Chinese companies and their adaptation. One of the common arguments was that the United States believes that powerful state support for technology sectors in China, along with the existing problems in protecting intellectual property rights, increases the risks and potential losses of American companies.

However, while these concerns seem reasonable at first, they should not be taken at the face value.

China’s ability to push out American companies in the high-tech sector on the world market seems rather limited. So far, China has only succeeded in increasing its share in the middle and low technology segments. Instead, in recent years, China is rapidly increasing its defense spending, which in 2017, for the first time, reached a level of 1 trillion yuan (about $150 billion). China’s defense spending is the second highest in the world after the United States. Moreover, it’s growing very fast. While in 2005 the Chinese nominal defense expenses were only 10% of American expenses, in 2018 they are already around 40%. The dominance of state enterprises in the defense industry in China implies that the real purchasing value of these expenditures is quite comparable. New and existing Chinese industrial policy programs target military and dual-use industries among others. Therefore whilst addressing the intellectual property rights problem in China now, Trump’s administration also aims at preserving US leadership position in the military sector, which finds widespread support in Trump’s main voter groups among Republicans.

Obsolete weapon

Historically, trade wars implied tariff escalations to protect domestic industries from foreign competition. Today, the Trump administration behaves in a similar manner. However, the circumstances now are fundamentally different from those in the first half of 20th century and earlier. Firms not only trade in final goods, but more and more they trade in intermediate products and within firms themselves (Baldwin, 2012). The distribution of the production process to many companies across different countries of the world leads to two important effects, which were not observed in previous trade wars.

First, it is the effect of the escalation of tariff protection in the framework of the value chains. The import tariff is applied to the gross value of the product crossing the customs border. However, the exporting firm’s contribution to the gross value might be quite small. So the effective level of the tariff will be higher than the nominal level of the tariff, known as a so called amplification effect  (World Bank, 2017, page 98). It means that the effective growth of the tariff by 25 percentage points in relation to Chinese imports will significantly exceed 25 % and in some cases can even become prohibitive. So, the tariff warfare will result in significantly greater losses for the sectors involved in the value chains, compared to the sectors less exposed to them. It means that foreign investors and multinational companies in China will suffer bigger losses compared to purely domestic Chinese companies. The Peterson Institute for International Economics made an assessment and confirmed these observations (Lovely and Yang, 2018).

Second, China’s participation in international multinational companies most often occurs in the assembly segments, while developed countries’ companies contribute at other stages, such as with innovation, design, financial and consulting services, marketing, and after-sales services. Then, the protectionist measures against goods produced in China by multinational companies will hit an American economy, generating losses in the service segments. A similar episode happened, for example, in 2006, when the European Union introduced anti-dumping duties on imported footwear from China and Vietnam, which in turn lead to a decline in the services sector in Europe – imported footwear contained a significant share of the value added created by European designers and distributors (World Bank, 2017). Obviously, we will observe the same consequences in the United States now, since the role of the American services sector in creating and promoting Chinese goods on the American market is significant and according to World Bank estimates in 2011, the contribution of value added generated by foreign services in China’s gross exports amounted to about 15% (World Bank, 2017).

Thus, not only the economy of China, but also the US economy itself will suffer from the growth of import tariffs in the USA. The USA is not an exception here – the governments of most countries continue to live in the paradigm of trade policy, which suits the structure of the world trade as at the beginning of the 20th century, while trade has gone far ahead and requires much more elaborate effective regulatory tools than tariffs on imported goods.

Consequences for Russia

The consequences of the US trade war with China for the Russian economy depend on what the main goals of the war are. If the motive is primarily electoral – to secure enough support in 2020, one can expect that the protective measures will be short-lived, and the geographical distribution of investment flows will remain almost intact and that China will remain an important location for global value chains transactions.  The trade war will in this case lead to some economic slowdown in the short term. The main effects will be related to the redistribution of income within economies, where protected sectors will benefit on the expense of all other sectors. In these circumstances, Russia would suffer direct losses from the growth of tariffs on their exports to US (now it is predominantly steel and aluminum), but for the economy as a whole, the losses will not be significant, especially relative to the losses Russia bears because of sanctions.

However, if the main reason for the trade war has a long-term perspective, the investors will be forced to adjust the geography of their investment plans and China will face a significant outflow of foreign investments, which will significantly affect Chinese – and global – economic growth. In this case, both for Russia and for the whole world, the indirect effect of the US-Chinese trade conflict will be quite noticeable and it will take years to create new trade links and restore world trade and global value chains.

References

  • Baldwin, Richard, 2012. “Global supply chains: why they emerged, why they matter, and where they are going”, CTEI Working papers 2012-13, The Graduate Institute, Geneve
  • Lovely, Mary E., and Liang Yang, 2018. “Revised Tariffs Against China Hit Chinese Non-Supply Chains Even Harder.” PIIE Policy brief, Peterson Institute
  • Office of the US Trade Representative. March 22, 2018. “Executive office of the President findings of the investigation into China’s acts, policies, and practices related to technology transfer, intellectual property, and innovation under section 301 of the trade act of 1974.”  https://ustr.gov/sites/default/files/Section%20301%20FINAL.PDF
  • World Bank, 2017. “Measuring and analyzing the impact of GVCs on economic development”. World Bank, Washington DC.

Note

A longer version of this brief has been published in Russian by Republic: https://republic.ru/posts/92217

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Between East and West: Regional Trade Policy for Ukraine

Posted on September 12, 2011 | Policy Brief

Policy Brief Building in Kyiv, Ukraine and Globe

Given Ukraine’s geographical location between Europe and Russia, the country often has to make difficult choices in its foreign policy. Trade policy is not an exception. In particular, Ukraine is currently negotiating a comprehensive free trade agreement with the EU, which is fostering hopes of joining it in the near future. However, at the same time, Russia is ‘inviting’ Ukraine to join the Customs Union it has created together with two other former Soviet Republics; Belarus and Kazakhstan. Since Ukraine cannot be part of both regional agreements simultaneously, it will again have to choose between the EU and Russia.

Over the last decade, the European Union has become the most important trading partner of Ukraine. The share of Ukraine’s exports of goods to the EU is now around 25-30 percent, while its share in Ukraine’s exports of services has increased twofold from 17 percent in 1994 to 34 percent in 2008. The share of Ukraine’s imports from the EU is even larger: around 35 percent in goods and more than 50 percent in services. This growth in trade shares has occurred despite the fact that there are still substantial barriers, both tariff and non-tariff, to free trade between Ukraine and the EU. The Free Trade Agreement (FTA) which Ukraine and the EU are currently negotiating is intended to remove many of these barriers.

The EU-Ukraine FTA is part of the so-called New Enhanced Agreement between the EU and Ukraine and consists of a set of provisions stipulating the liberalization of trade in goods and services, capital movement and payments, and government procurement.

A big part of the agreement is devoted to the trade in goods. This is perhaps not surprisingly so given that trade in goods accounts for 80 percent of their total bilateral trade in goods and services. Tariffs that Ukraine currently applies to the EU non-agricultural imports vary from 0 to around 20 percent. Under the new agreement, the tariffs on many of these goods will be reduced.

Apart from tariffs, the agreement stipulates an elimination of many non-tariff barriers to trade. This will be achieved by harmonization and simplification of the procedures related to customs and licensing, capital movement, government procurement, and intellectual property rights (IPR) protection, as well as competition policy, energy security and others. Ukrainian legislation must be standardized to conform to the respective European laws, with some procedures becoming more transparent (tenders), while others becoming more stringent (IPR). For example, Ukrainian producers will have to abide by the legislation on trademarks and geographical names. According to the Ukrainian deputy minister of Economy, the EU has offered a grace period of 5-10 years to Ukrainian producers to re-brand their products.

The FTA negotiation process between the EU and Ukraine started on February 18, 2008. Since then, more than fifteen rounds have taken place. Initially, there were hopes that the agreement would be signed before the end of 2010. However, in the fall of 2010, it became clear that this was not going to happen. Currently, the more pessimistic experts expect the agreement to be signed only in 2013.

In parallel with the EU integration processes, Russia, Belarus and Kazakhstan have created a customs union and are actively trying to involve Ukraine in their union. On the one hand, the Customs Union is attractive for Ukraine since it offers free trade with Russia, which is still one of Ukraine’s biggest trading partners, both in terms of imports and exports.

This union promises access to cheaper energy resources, which would be beneficial for Ukraine given its high energy dependence, especially in the exporting sectors like metals and chemicals. However, joining this Customs Union would jeopardize the FTA negotiations with the EU and would even endanger the WTO membership of Ukraine.

So far, the Ukrainian government has not taken a clear stance on whether Ukraine is going to become a full member of the Customs Union. Instead, it has cautiously offered a “3+1” arrangement.

In the light of the above discussion, the natural question to ask is then: what integration strategy would Ukraine benefit the most from?

Regional Trade Agreements

The idea that regional trade agreements (RTA) are beneficial to a country is best supported by the fact that such agreements have become increasingly popular over the last twenty years. As of July 31, 2010, there were around 400 RTAs reported to the WTO with 193 being in force. According to the World Bank, on average, a WTO member has regional agreements with more than 15 partner countries. RTAs exist predominantly as free trade agreements (FTA) and customs unions (CU). The former removes barriers to trade in goods and services among member countries but allows individual members to set their own tariffs against third parties. The latter type is a stricter arrangement since customs unions act as a single agent in the world markets and have a unified external tariff regime.

The analysis of RTAs and customs unions in particular, dates back to Viner in 1950 who introduced the terms trade creation versus trade diversion. Trade creation refers to a situation where member countries begin to trade goods and services with each other after the creation of an RTA, whereas previously they produced them domestically. Trade diversion, on the other hand, occurs when member countries shift their imports from outside partners to inside partners. Obviously, while trade creation is viewed as a good consequence of a RTA, trade diversion is undesirable. This, since the lower tariffs, make member countries shift away from the most efficient outside producer to an RTA partner.

There are two approaches in the literature to evaluate the impact of the RTAs: gravity models and general equilibrium (GE) models. Gravity models are estimated on the actual trade data while GE models are used for simulations. The typical findings on the effect of RTA’s are that: (a) excluded countries almost always lose, (b) there is a trade creation effect but it is rather small, and (c) the effect of the RTAs differs across their members, in particular, smaller countries tend to experience a larger increase in their exports (World Bank, 2005; Berthelon, 2004).

In addition, the so-called South-North RTAs (agreements between developed and developing countries), are found to be more beneficial for the latter than South-South agreements. Finally, the literature shows that on average FTAs are associated with lower levels of tariffs compared to customs unions.

Ukraine’s Choice of Trade Policy

The above presented empirical findings on existing RTAs, can offer guidance in which of the regional agreements Ukraine would benefit the most from. First, on the one hand, both of the FTA with the EU and the Customs Union with Russia are likely to lead to higher trade volumes (trade creation). On the other hand, the FTA with the EU can be regarded as a South-North agreement and could, therefore, be expected to have larger benefits for Ukraine than the Customs Union with Russia. Another argument in favor of the EU-FTA, is that Ukraine’s other trading partners are likely to face higher tariffs if Ukraine became a member of the Customs Union, than if she signed an FTA with the EU.

A recent study by Shepotylo (2010) addresses this issue and can be used as a benchmark for the analysis. Shepotylo uses a gravity model to compare potential export gains from deeper integration with the CIS countries to those from integration with the EU. Shepotylo’s analysis evaluates whether integration would be trade creating or not, leaving aside the issue of trade diversion.

Based on past experiences of Eastern European and CIS countries, Shepotylo builds two thought experiments. The first one is based on the scenario in which Ukraine would have become more deeply integrated into the CIS structure. That is, the experiment allows us to see what would have happened to Ukrainian foreign trade over the period 2004-2007 if Ukraine had developed closer ties with the CIS countries. The second experiment envisages what would have happened if Ukraine would have joined the EU in 2004.

According to the results, Ukraine would have benefited under both integration scenarios relative to the current situation of no integration. However, the benefits would have been twice as high under the EU integration strategy. Shepotylo’s results suggest that the EU integration could have increased Ukrainian exports in 2004-2007 by 10 percent, while the deeper CIS integration would only have increased exports by about 4 percent.

The highest expected benefits of Ukraine’s integration into the EU would have come from a substantial increase in export of various types of machinery and equipment, road vehicles and transport equipment, as well as apparel and closing accessories. These gains would have been virtually uniformly positive and economically large across all groups of countries regardless of the membership in EU. For example, export of road vehicles to the CIS countries would have been 88 percent higher under the EU integration scenario than under the CIS integration scenario, while their exports to the Western Europe would have been 82 percent higher. The export of raw materials, on the other hand, would have either declined (nonferrous metals), or remained relatively stable (iron and steel).

More importantly, gains under the EU scenario would also have come from a more diversified trade structure. A higher export diversification would be achieved because of the rapid expansion of manufactured exports, the share of which in total export would have been 26 percent under the EU scenario and only 16 percent under the CIS scenario.

In our view, diversification of trade flows is very important since a more diversified export structure with a high share of manufactured products can better protect a country from negative terms-of-trade shocks. For example, export diversification reduces the effect of idiosyncratic shocks. This was found by Koren and Tenreyro (2007). According to their findings, low-income countries which specialize in fewer and more volatile sectors, experience higher aggregate volatility in terms of GDP growth rates and trade volumes, etc. Another reason to why a more diversified trade flow (i.e. moving away from exports of primary goods to exports of manufactured products) is desirable, is the general trend of declining prices of primary commodities relative to the prices of manufactured goods. Also, a diversified export structure with a higher share of technologically advanced products has been found to be conducive for higher economic growth (Hausmann et al., 2007).

Conclusion

The above analysis suggests that signing a deep FTA with the EU would benefit Ukraine the most. This, given that it is likely to lead to a substantial increase in total exports and a favorable change in export composition towards a more diversified structure with a higher share of technologically advanced goods. These developments could in turn lower macroeconomic volatility and boost economic growth. Also, the EU integration scenario considered by Shepotylo (2010) did not allow for a substantial liberalization of trade in agriculture – an area where the large EU market is most protected. If the Ukrainian government manages to negotiate more open trade in agriculture, Ukraine may potentially gain much more than predicted in Shepotylo’s experiment.

On the other hand, joining the Customs Union with Russia would enhance the trade with its members and secure a lower price for energy resources. However, the benefits are likely to be outweighed by the potential losses of other markets and complications with the WTO due to the increased level of protectionism – an inevitable consequence of joining the Customs Union. In addition, the Ukrainian trade structure would become even more concentrated and skewed towards primary commodities, making the country even more vulnerable to shocks and slowing down its economic development.

Recommended Further Reading

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.